I seem to have spent half the week explaining free trade and the concept of comparative advantage to people who are fearful of the rise of China and India.

When you see a country doing far better than it was two decades ago in industries your own country once dominated, it’s easy to be spooked.

Yet the lesson of the past couple of hundred years is that those who have traded have prospered, while those with closed borders have languished. (Free free to send me a postcard from North Korea with evidence to the contrary).

Even the rise of China can be put down to it joining the WTO.

It’s true that both it and India – and many emerging countries – seem to do best when they protect certain domestic industries rather than relaxing all their trade restrictions, but that’s a long way from saying free trade is bad.

But what about the US? Hasn’t it run up a huge deficit partly by buying cheap Chinese goods instead of American made products?

Well, no. Leaving aside whether the US is half as indebted as its critics suggest (they tend to ignore assets) the fact is that American consumers have enjoyed a decade of cheaper trainers, jeans, computers, and iPhones on the back of free trade. Their bucks went further.

You might argue those things weren’t worth exchanging some of the future wealth of US citizens for, but it’s wrong to deny they have no economic value.

International free trade makes us all richer

The empirical evidence in favour of free trade is very strong, but there’s also a solid theory behind it.

What’s more, the theory supporting free trade is 200 years old!

It was the British economist David Ricardo who first realised that free trade between two countries would make the citizens of both better off – even when one country is much better at doing everything than the other!

Ricardo used the example of England and its oldest ally Portugal to illustrate.

Assume England and Portugal make and trade just two products – cloth and wine. Imagine that England is worse at making cloth than Portugal. Yet thanks to the bad British weather, it’s even worse at making wine!

In other words, Portugal is more productive than England in both wine and cloth.

In these circumstances, you might think Portugal would be better off making everything it needs for itself, since it can make both wine and cloth more efficiently than England.

But in fact, it’s best for everyone if Portugal trades its wine for cloth made in England. This is because the total output of the two countries will rise.

Seems wrong, doesn’t it? Let’s look at some example figures (inspired by David Smith’s Free Lunch economics primer).

First for wine:

• Sunny Portugal finds it easy to make wine. 25 workers can produce a barrel of wine a day.

• In rainy England, it’s hard. 200 workers are needed to make a barrel a day.

Now for cloth:

• In Portugal, 25 workers are also needed to make a roll of cloth.

• Back in England, 50 workers are needed to make a roll of cloth.

Clearly Portugal is best off making wine. But Portugal also has an absolute advantage in making cloth.

Is there anything England can do?

Ricardo explained that in this circumstance, it’s best for Portugal to switch production from cloth to wine, and for England to switch the other way.

Let’s say both countries have a population of 1,000 workers. These workers happen to be divvied up between the two industries such that:

• Efficient Portugal produces 1,000 units of wine and 1,000 of cloth a day.

• Less efficient England turns out just 125 units of wine and 500 units of cloth.

Remember from the numbers above that England needs four times as many workers to produce wine (200) than cloth (50).

• If England switches all its inefficient wine production to making cloth, it will now make 1,000 units of cloth a day.

That’s a big boost in output – but now the English have no wine?

In these circumstances, free trade will see Portugal switch some workers from cloth production to its equally efficient wine production, in order to satisfy the English demand for wine.

Because Portugal is equally efficient at producing both products, it still produces 2,000 units of goods a day.

But English productivity has soared!

It’s 1,000 workers now produce 1,000 units of goods a day, instead of the 625 units they were producing before they switched to cloth and instead imported wine from Portugal.

• Total output (GDP) has therefore risen from 2,625 to 3,000 units a day.

This example shows it is comparative advantage that matters in trade, not absolute advantage.

What’s in free trade for Portugal?

You might wonder why Portugal should bother doing the switch. Why buy less efficiently produced English cloth?

As Smith explains in his take on Ricardo’s example:

“The answer is that the price of English cloth will be determined by ‘world’ levels. English cloth workers, because they are half as efficient, will tend to be paid half as much as Portuguese workers. The Portuguese will thus be able to afford to buy a significant proportion of the increase in world output.

“There is still a gain for England and its workers, though, from moving from appallingly inefficient wine production to cloth. It’s a win-win.”

Think about trade with China to see this happening right now. Our own factories are far more efficient than Chinese labour-dependent ones. But we readily buy stuff made in China, because the cost of most goods produced there is so much lower.

If you’re interested in the minutia of free trade and Ricardo’s law of comparative advantage, there’s plenty to be debated. What about transportation costs? What about the cost of switching production?

The main point though is that it’s good for everyone for countries to do what they’re best at. We will all be better off from free trade, albeit at the cost of allowing poorer countries to close the gap with richer ones.

I caught an interesting interview with asset stripper / investor Wilbur Ross the other day.

For the unacceptable face of capitalism, Ross made a pretty good show of it. For a start, he revealed his childhood ambition was to be a creative writer. So was mine!

More importantly, in his telling, Ross’ key move to restructure the US steel industry was on the side of the unions and against ineffectual management. He made billions saving the rust belt from itself.

But I was most struck by a comment he made about investing in bankrupt steel company LTV in 2001, for which he was initially pilloried.

Far from being the crazy risk taker his critics suggested, Ross said:

We’re in the business not so much of being contrarians deliberately, but rather we like to take perceived risk instead of actual risk.

What I mean by that is that you get paid for taking a risk that people think is risky, you don’t particularly get paid for taking actual risk.

So what we had done we analysed the bid we made, we paid the money partly for fixed assets, we basically spent $90 million for assets on which LTV had spent $2.5 billion in the prior 5 years, and our assessment of the values was that if worst came to worst we could knock it down and sell it to the Chinese.

Then we also bought accounts receivable and inventory for 50c on the dollar. So between those combination of things, we frankly felt we had no risk.

That’s the sort of value investing approach that made Ben Graham, Walter Schloss, and Warren Buffett their fortunes.

And while telling perceived risk from actual risk is far from the cakewalk that Ross implies, it’s a vital concept to understand –  whether to give you faith to invest against the crowd, or for anyone silly enough to indulge in picking stocks.

Risk junkies or sober investors?

Let’s highlight that key quote from Wilbur Ross on risk:

You get paid for taking a risk that people think is risky, you don’t particularly get paid for taking actual risk.

The first thing to say is this is a very different concept from the risk of efficient market economists. When they say ‘risk’, they mean what I’d call volatility.

More specifically, according to the efficient market hypothesis, risk, reward and volatility are all part of the same cat’s cradle – you can’t get one without taking on the other.

Remember: most economists don’t believe it’s possible to say one share is cheaper than another. To get higher rewards, you can only blindly put your money into riskier (that is, more volatile) assets.

To which Warren Buffett might reply: Never mind the theory, feel the size of my bank account.

Value investors like Buffett and Ross (or growth investors, or indeed any kind of non-passive trader) believe they can identify situations where they are paying 50p to buy £1 worth of company.

They call this the ‘margin of safety’, and say that it reduces the risks they take – because they are buying more cut-price assets – while increasing the reward – because they can eventually sell those assets for higher prices.

Where do such opportunities come from?

You might ask why anyone would sell a share worth £1 for 50p?

This brings us back to Ross’ concept of perceived risk. A value investor could argue that perceived risk is higher than actual risk because of:

• Oversight – An investor may identify company assets he believes the market has overlooked, allowing him to ascribe a value of say £1 on a 50p share.

• Underrating – The share may be trading correctly on its current prospects, but the market may have overlooked its medium to long-term potential. Think of Buffett’s investment in Coca-Cola, or more recently Burlington Rail.

• Fear – The biggie. When the market is fearful, most share prices are indiscriminately slashed. If you correctly judge that the fear is overdone, picking up bargain shares in a bear market is like hitting three gold bars on a fruit machine.

Don’t try this at home

Sounds easy, doesn’t it? Unfortunately it’s not.

Most people fail to beat the market when they try stock picking. It’s a scientific fact. Review the psychological quirks that can make you think you’re better at it than you really are.

In my view buying more shares when times look bleak and rebalancing your portfolio towards safer investments when everyone is bullish is a bit safer.

That’s the classic Ben Graham approach of varying your stock allocation between 25% to 75% depending on how cheap the market looks, and it’s a good one because you never sell out completely – and so should avoid your dodgy market calls losing you a lot of money.

That’s important, because again most people are bad at such market timing. Private investors tend to put most money into the markets around their highs, and pull out their cash in the lows. And all this churn costs fees and taxes, which is a net loss from private investors to the finance industry.

As ever, you’ll probably be better off just passive investing through the highs and lows of the market.

Hindsight is the best investor

Being a stockpicker as well as a strategic asset allocator, I’m admittedly a fine one to talk. If you too decide to walk this dubious path, then read some behavioral finance to try to get an edge in deciding what’s a perceived risk versus an actual risk.

As Tim has written on his Psy-Fi blog, it’s usually emotion, not the rational judgment of risk, that we should bet against:

Sectors with a buzz about them get rated higher than those with bad vibes. Value investors take note: done properly excess returns can be achieved without real extra risk.

Yet even this isn’t a sure thing. Alan Greenspan famously warned of ‘irrational exuberance’ in the tech stock market in 1996, but it was easy to quadruple your money by riding the bubble in the four years that followed. If you avoid what’s popular too soon, you’ll be risking lower returns.

Ultimately, perceived risk and actual risk are in the eye of the beholder. Only hindsight can be sure which was which.

Apologies to those who logged in yesterday for our regular link smorgasbord. Some good friends invited me onto their canal boat for a bit, and there I stayed!

As a conscientious objector to the ongoing war between the older and younger generations via UK house prices, I’ve wondered about running away at 4mph on a canal boat.

Sadly, as best I can work out narrowboats depreciate with a half-life of around 10 years. They’re not cheap to begin with, either – £40,000 to £80,000 or more used, and much more brand new – and they also eat up a couple of thousand annually to keep from rusting.

Then there are mooring fees, or rent by another name. Few boat owners can genuinely continually cruise the waterways (which itself costs around £800 a year in licences) so most need a permanent base. The better residential ones in London cost £4,000 to £8,000 a year, though elsewhere is cheaper.

As someone wise once said:

“A boat is a hole in the water that you pour money into.”

If I eventually do try living ‘on the cut’, you will learn about it here.

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